Russell Napier of the Electronic Research Interchange (ERIC) said that
at the moment central banks are net sellers of treasuries.
“The central bankers do not have to sell anything to buy treasuries and fund the government. They print something,” said Napier.
“For my entire investment career the US government has been primarily funded by foreign and local central banks,” he added.
Edited Excerpt: "It’s an incredibly attractive level for many investors all over the planet obviously mainly due to the incredibly low level of yields in Japan and euro zone and therefore, it begin to attract investment,” said Napier.Q: Most people in the world seem to be quite worried about inflation returning and bond yield soaring but you seem to have a different point of view that maybe the cookie will not crumble entirely like that maybe will have a growth scare rather than inflation scare? Why do you have that contrarian point of view? A: I do and I understand why people have that view and it is very much based on Phillips Curve view of the world which is tightness of employment. There are two things I would put forward as the contrary view. One is the supply of money which is not a very fashionable thing to look at these days. It comes and goes but its growing at incredibly low rates globally, for instance let’s pick America; it’s growing at 3.7 percent year-on-year. There is only 16 percent of all quarter since World War II where the supply of money has been growing that slowly and if we look at across the world whether even its in India; much higher number but at the lower end of the range, China with close to a record low growth in money supply.
So there is a simple question I ask people who are much more optimistic about inflation. I say if you are expecting higher inflation, higher real growth and higher asset prices, which I think is a consensus view, how come we have got close to record low global money supply growth, something doesn’t add up. So one of the three variables that people are forecasting is likely to be wrong and may not be inflation. It could be real economic activity, it could be asset prices but it’s difficult to see the other two adjusting without having some negative impact on inflation.
The second one is just credit; when you have and what we do have is highest level of debt to gross domestic product (GDP) ever in the history of the world as we discovered with Lehman Brothers. You just need one significant mistake and the global financial system finds itself struggling and as we know from Lehman Brothers - that’s a deflationary rather than an inflationary adjustment – and people who watch me regularly on internet, I had referred to Turkey as the next forthcoming significant default in the global system. I think $434 billion default on the global financial system. I think that’s big enough to bring down growth expectations, to join the financial system and to help people looking more at the decline of inflation rather than the rise of inflation.
Q: You think that if an accident were has to happen this time it would be a country accident like Turkey and not a financial system kind of an accident? A: Almost by definition what accident means is it’s very hard to what it would be in predicting, but the thing about Turkey is a clear and present danger and it’s obvious that several of the largest companies in the Turkey are simply not paying their debt. The BIS has also done some really interesting work with all this debt to GDP data looking at growth rate and debt to GDP relative to trend and they have picked over ten countries that they think could have credit crisis.
So this is interesting because most of the emerging markets -- actually there are two developed countries that they have picked is having such a high rate of growth in credit that they could be dangerous which are Switzerland and Canada but everything else is in the emerging markets. So there is evidence to an extent that we can ever be objective about an accident that there are quite a lot of place due an accident because of just a sheer growth and credit we have seen since the global financial crisis (GFC).
Q: How imminent would it be though because these things can carry on for a long time, protracted period of time before they come to fruition? Do you think it is really at the door or it can linger from much longer? A: You do not have to tell me they can take a long time to come to fruition because particularly on Turkey I have been sort of saying for several years that it’s coming to pass. Obviously there are different stages of this and what is the critical stage. The stage which is imminent, it is simply when people stop paying interest on their debt and that is what Turkey is now and if the very largest companies in a country are really struggling, you can be sure that below that the smaller companies will be having real problems.
The exacerbating factor that makes it more forecastable than usual is that so much of debt in foreign currency and we know from the United States, from Japan that domestic currency debt can be sustained for a very long time. I think it is almost impossible to forecast based on domestic credit boom, but the problem for Turkey and some other particularly eastern European countries is the massive level of foreign currency debt that they have on the falling exchange rate. So I think for those it’s imminent. The interesting thing is what happens after that.
In 1982 and 1997 when a major emerging markets got itself into trouble. It changed capital flows for all emerging markets perhaps unjustly. I think it’s isn’t just that emerging markets get lumped together but it still happens that assets are still held in silos and we will see a capital exodus from other emerging markets and I wouldn’t expect to find others being kept over into insolvency but I would expect them to be looking at generally much lower levels of growth, but it’s very difficult to predict that – just the extent of the capital outflow that incidence post Turkey and just how much trained individual markets will come under, but I am concerned, post global financial crisis (GFC) this is the biggest debt in the emerging market history and it is where for all of that credit to be allocated.
Q: Keep the accident aside. Are you seeing any signs from the biggest market, biggest economy that growth maybe beginning to rollover and you will not get the kind of inflation scare that people are talking about? A: Not particularly. In 1990s when actually US growth was very good and inflation was coming down. We always related and said that the view that world is very much a Phillips Curve view and if the jobs market is tight, if wage growth is better than bad then there has to show off in inflation and on particular occasions in 1990s America imported lot of deflation and the fact was low inflation. So you can have reasonable growth without having rising inflation. I think that is not the common view where we are but that’s still very possible and I do not have to do through for people watching a massive technological changes that are happening in the world that are deflationary rather than inflationary.
My concern in America really relates to financial markets more than growth and that is what is happening in the treasury market where we have a fiscal deficit now running close to a trillion to effectively double over the past three years. We have a central bank which this year will sell $380 billion worth of securities rising to $600 billion next year and in through my entire investment career the US government has been primarily funded by foreign and local central banks.
Central banks do not have to sell anything to buy treasuries and fund the government -- they print something -- and we are now living in a world where central bankers are net sellers or treasuries and therefore, it all has to be funded by savers; they could be Indian savers, they could be Japanese savers, Germans savers or American savers, but I worry about the level of the stock market and a world where we have to liquidate something to fund the government and that said saves have two ways they can fund the US government; save more which is bad for growth or sell something else to buy treasuries. So I think the concern is now directly on US growth but it’s what might happen to other asset prices as they are liquidated to fund this huge supply of US treasuries.
Q: Do you see a problem with the US corporate bond market at all given the way yields have moved? A: If we talk about places where there have been excessive growth and credit. In aggregate you cannot point United States of America. I think everybody who covers financial markets realizes that there is section of credit within America which is junk, which is once again been growing pretty quickly. Whether there is significant enough catalyst undermine cash flows to crawl a problem there, I think that is we just have to wait and see. There is a significant boost to US cash flow going on thorough tax rate and that bit of a credit market that looks susceptible because it’s a high risk credit – those have disadvantages of lower tax rate. So on that one the jury is out. I do not have a strong view on US high yield. It seems like an accident waiting to happen but I do not see the catalyst for it happening.
The problem I think is that the discrepancy actually between that debt and emerging market debt - so we have a pretty significant selloff in emerging market debt and fairly moderate in American high yield debt and that causes great problems for the world because the Federal Reserve is much more interested in its own high yield market than it is in emerging market debt and twice in the last five years the Federal Reserve has changed its monetary policy to help emerging markets.
I think what is really important is the speech that Jerome Powell made in Zurich a few days back when he said that the Federal Reserve did not believe in any responsibility for capital inflows and capital outflows of emerging markets. So we have this discrepancy with US high yield seemingly stable, no issues with credit in America but meanwhile real credit issues building up in emerging markets. So that high yield debt market is really interesting and it might show that when it begins to crack we should be worried but actually if it begins to stay stable and doesn’t crack there is another reason to be worried which is that Powell continues on his tightening track regardless of the pain developing in selected emerging markets.
Q: What is the path of least resistance for the US bond yield now? Is it 3.5 percent or 2.5 percent? A: It is amusing to me. Everyone has becoming an expert of US bond yield since it go through the magical number of 3 percent – suddenly everybody’s grandmother is an expert on the US bond market - and when you began with a price and forecast backwards, I am always kind of worried about that. I am not saying that the fundamentals always help you but if disturbs the fundamentals and go to the price. So my view is that we are quite close to peak on the US bond yields that it’s at an incredibly attractive level for many investors all over the planet.
Obviously mainly due to the incredibly low level of yield in Japan and in the euro zone and therefore it begin to attract investment that obviously help but I do not think inflation is a problem, so most people look at 3 percent yield and think it’s just reflecting tight labour market and they never rise of inflation.
So for that yield to peak and begin to come down again, I think we all have to see some data which makes people question that are for US inflation or any credit event that is a flock to the world’s most liquid asset and United States treasuries retain that position and credit event after credit event but if it’s a sizeable one anywhere in the world; treasury prices will be a bit up and the more we give expectations from emerging market growth then the more we look to lower inflation.
So I think we are close to a peak despite the numbers that I have just given you for successively large supply of treasuries and one of the reasons that the dollar is going up is that foreigners aren’t find it very attractive. If I will tell you there is a country that is issuing a lot of debt you might think we will have to sell US equities to buy all of that – it’s possible but it’s possible that we sell German equities or Japanese bonds and the fact that the dollar is going up – that suggests a lot of capital coming into the US and their 3 percent yield is proving attractive particularly for foreign investors.
Q: Do you have a view on the dollar, do you see it strengthening further? A: I do see it strengthening further. Everything I have said so far would suggest a strong dollar. Exchange rate forecasting is probably the most difficult thing of all of the big liquid deep markets. However there are rare occasions when a dollar becomes really quite forecastable and it is a credit event. It is a situation where the world starts to degear. In a world of rising gearing what happens is, many people in the world tend to borrow dollars.
They may use that to fund investments in India, they may use it to fund construction projects in Turkey, they may use it right across the emerging markets. However when we have a credit issue, when credit becomes less available or people wish to repay it to reduce the risk then that position is buying of the dollar as people move back and pay off those liabilities. So, if we are looking at Turkey going to into defacto default for the imposition of exchange control, I think we are looking at a de-gearing event.
The two other major currencies in the world have unique problems - Japan has unique problems, it has no savings left to fund its government through central bankers and over the long term it has always been bad for exchange rates. In Europe we still have this problem, that the fiscal integration / political integration of Europe has really hit a road block and it is difficult to see how a single currency functions unless progress comes into that integration. It seems that the people are voting to a different direction- away from integration and towards greater independence and sovereignty. It is very difficult to be bullish on the Euro.
So, dollar almost by default because of what is happening in the other two but specifically because of the credit advantages has always spiked the dollar higher.
Q: Where does this leave emerging markets because usually the two move in opposite directions? A: It is really sad that lump together, the fact that policy makers in Turkey have made some dreadful mistakes, why should that have any impact whatsoever on India, China or anywhere else? Unfortunately it does because the capital flows are lumped together. For instance there are lot of emerging market bond funds and emerging market equity funds and if they start getting redemptions they pull out almost from all of emerging markets. So, emerging market risk has been pushed onto very low levels by the fact that US interest rates are so low.
So, for all emerging markets we will see the risk premium reset. I know you are going to ask me about India in this context but the ones where there should be massive reset are the ones where the politics are completely in the wrong place, like Turkey but there are lot of others like the Philippines, Hungary, Poland, Mexico, what I mean is the kind of old politics of more control, restrictions on markets, that is the dangerous populism for investors. I don't see any of that in India, people watching may have a different opinion but the current political setting in India even if the growth is slow, I don't see the current political setting being pushed off course.
This is going to be a very important test now for all emerging markets, how do you respond if there is another downdraft and I think the politics of India are such that they would pretty much keep to the same track. However there are other places in the world that would probably go in different direction.
Q: How do you see India's macro setting now? A: I see it as very positive, I look at interest rates which have gone up but they are still low by historical standards, inflation is low by historical standards, money supply growth is low by historical standards, current account deficit is low by historical standards, the ability to attract capital which I think is absolutely crucial thing seems to be very good and can go higher. So, I wouldn't even worry if the current account deficit got bigger, I think the policy settings are attracting capital.
It is strange for me to relate that when I started in this business the Berlin wall came down and what we all knew instantly was that all these new emerging markets that were open for business were going to have to run a huge current account deficits because they are going to have to attract a lot of capital. They did not have large savings, they are going to have to use other people's savings and as the current account and the capital account were mirror images of each other and then what actually happened, take for instance someone like China, they run a huge current account surpluses and the whole thing did not make any sense. So, we are kind of preconditioned to believe that large current account deficits aren't necessarily a bad thing for emerging markets.
For a country of the size of India, if it can genuinely attract capital which has been the country's problem for many decades, but if that has genuinely changed now, then the country can be much more stable going forward. I would stress and I think if you get a chance to chat to Raghuram Rajan, you should really ask him about this. The key thing is to get long term capital and not the portfolio capital and it seems India is doing good job at both. So, the moment this long term capital comes along, actually many of the historic issues that India has had become less and less important going forward.
There are many other things that are going well in India, obviously we have issues with your banking system but at least there are private sector banks in India who are doing a better job, that is not true in places like China. So, I remain very optimistic long term about India. I find myself embarrassed because I always say that and then I say don't buy in the stock market. I find difficulties with the valuation in the stock market, we are looking at an emerging market problem coming along, India will be caught in the downdraft but not as badly as others. In fact that is a buying opportunity for long term investors. If I was asked to put anywhere in the world for the next 10 years, I wouldn't hesitate to buy Indian equities on that timeframe. Macro isn't always connected to the stock market.
In fact we can show 117 years of data for returns from nearly 20 stock markets across planet now and we can see there is virtually no relationship between GDP growth and the return you get from equities and that is because of valuations. If you pay the wrong price for equities, you could still get it wrong in the long run. So, cautious on the market but not cautious on the macro settings for India. This transformation and foreigner's willingness to invest in India can bring many things into line for very good outcomes.
Q: Since you are predicting a looming emerging market crisis, what is your best guess of the timing? Do you see it happening in 2018? If you had to guess, would you say it might happen this year? A: Yes, the reason I would say that is because it seems to me that Turkey is already on the verge of default. So, it is not forecasting that this will happen in Turkey, it is happening as we sit here. The President has called a snap election for 24th of June, I believe that if he can make it that far and if gets re-elected, he will then take extreme measures to shore up Turkey which would constitute in one form or another exchange controls and would have an instantaneous impact on capital flows to all emerging markets. So, normally I would say I couldn't possibly forecast but on this occasion I would say 24th of June. Q: Is there any chance in your eyes that the long US growth cycle that we have seen for the last many years, both from an asset price point of view and from an economic point of view, that is beginning to come to an end and you could even think of a US recession a year or two down the line? A: It is possible. You know the statistics - for how long on average these expansions have lasted and this is already a very long expansion, a very shallow one, not very robust one. So, it could end at any time. There are very few ways that you can forecast a US recession, obviously an inverted yield curve is number one historically. People argue now whether the yield curve is indicative of true economic conditions as it used to be. However we would all be foolish to ignore the yield curve. So, rather than forecasting you should say what should you look at? I would say look at the yield curve. I am personally forecasting that 10-year yield isn't going up, so that means you could have an inverted yield curve really quite soon.
The reason I am being a little bit cautious about all of this and perhaps more cautious than usual is, thinking back to the late 1990s, we had this emerging markets issue, crisis is too strong a word, some countries have crisis but it is just downgrading of growth for emerging markets, it is not the Asian crisis or something like that, but when it happened last time, America imported deflation, interest rates stayed fairly low and growth in America stayed fairly high and I think you could say with the benefit of hindsight that the whole economic cycle was extended by the emerging market crisis. The central bank was on hold, actually cut rates in 1998.So, I am a little bit concerned, now that we are on the verge of this event in emerging markets, could that extend this cycle? Once again, there is a difference between extending an economic cycle and saying the stock market is going up. Extending this economic cycle actually could be a side effect of something of a lower growth, lower inflation outlook from emerging markets.